AQA A-level Economics
4.1.8.1 How markets and prices allocate resources
The Price Mechanism
Functions:
The price mechanism determines the market price. Adam Smith called this ‘the
invisible hand of the market’.
Resources are allocated through the price mechanism in a free market economy. The
economic problem of scarce resources is solved through this mechanism. The price
moves resources to where they are demanded or where there is a shortage, and
removes resources from where there is a surplus.
The price mechanism uses three main functions to allocate resources:
o Rationing
When there are scarce resources, price increases due to the excess of
demand. The increase in price discourages demand and consequently rations
resources. For example, plane tickets might rise as seats are sold, because
spaces are running out. This is a disincentive to some consumers to purchase
the tickets, which rations the tickets.
o Incentive
This encourages a change in behaviour of a consumer or producer. For
example, a high price would encourage firms to supply more to the market,
because it is more profitable to do so.
o Signalling
The price acts as a signal to consumers and new firms entering the market.
The price changes show where resources are needed in the market. A high
price signals firms to enter the market because it is profitable. However, this
encourages consumers to reduce demand and therefore leave the market.
This shifts the demand and supply curves.
The price mechanism is the way in which the basic economic problem is resolved in a
market economy.
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AQA A-level Economics
The advantages and disadvantages of the price mechanism and of
extending its use into new areas of activity
The price mechanism is an impersonal method of allocating resources.
Introducing the price mechanism into some fields of human activity could be
undesirable.
In the price mechanism, the invisible hand can signal what the cost of purchasing a
good is to a consumer. It also acts as a signal to producers to tell them what revenue
they will receive.
The price mechanism allows the consumer to gain sovereignty in the market. They
have ‘spending votes’ in the market, which enables them to choose what is bought
and sold.
Generally, the free market allows for an efficient allocation of resources.
However, there may be inequality in income and wealth with the price mechanism. It
does not consider what the distribution of income is. Those with money have buying
power, whilst those without money are left out.
Essentially, the price mechanism and the free market ignore equality. To evaluate, it
can be argued that inequality exists, but the degree of inequality may vary between
capitalist societies.
In a free market, there is the under-provision of public and merit goods, which
requires government intervention.
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